Investment returns over the next five years are likely to slow: Shane Oliver
EXPERT OBSERVER
The past five years have seen pretty good returns for well-diversified investors.
While cash and bond returns have been modest, growth assets have been strong.
Average balance growth superannuation funds have returned 8.5% pa over the five years to June and that’s after fees and taxes.
This is particularly impressive given that inflation has been around 2%.
Shares have climbed a wall of worry in recent years with a revolving door list of worries around Europe, deflation, inflation, rate hikes, Trump, North Korea, China, trade, house prices, etc. And unlisted commercial property and infrastructure have benefitted from an ongoing search for yield. But can it continue over the next five years? This note looks at the main issues.
Declining medium-term return potential
While investment returns have been good, the medium-term (say 5-10 year) potential from major asset classes has been moving down.
Investment returns have two components: yield (or income flow) and capital growth.
Looking at both of these components points to lower average investment returns over the next five years compared to the last five years.
First, it’s well known that investment yields are not what they used to be. Back in the early 1980s the medium-term return potential from investing was pretty solid for the simple reason that interest rates, bond yields, dividend yields and rental yields were so high.
The RBA's "cash rate" was around 14%, 3-year bank term deposit rates were around 12%, 10-year bond yields were around 13.5%, property yields were running around 8-9% and dividend yields on shares were around 6.5% in Australia and 5% globally.
Such yields meant that investments were already providing very high income and only modest capital growth was necessary for growth assets to generate good returns.
As it turns out, most assets had spectacular returns in the 1980s and 1990s and balanced growth superannuation fund returns averaged 14.1% in nominal terms and 9.4% in real terms between 1982 and 1999 (after taxes and fees).
Since the early 1980s, investment yields have mostly fallen and this has continued over the last five years. See the next chart.
Today the cash rate is 1.5%, 3-year bank term deposit rates are 2.5%, 10-year bond yields are 2.5%, gross residential property yields are around 3%, commercial property yields are just above 5%, dividend yields are still around 5.3% for Australian shares (with franking credits) but they are around 2.4% for global shares. This on its own points to a lower return potential.
Second, the capital growth potential from growth assets is likely to be constrained relatively to the past reflecting more constrained nominal economic growth. Several megatrends are likely to impact growth over the medium term.
These include:
An ongoing backlash against the economic rationalist policies of globalisation, deregulation and small government, thanks in large part to weak wages growth and rising inequality resulting in populist, less market friendly policies – such as trade protectionism and rising regulation.
Rising geopolitical tensions – most notably as the US attempts to constrain the rising power of China.
Aging and slowing populations – resulting in slowing labour force growth and rising pressure on public sector budgets.
Constrained commodity prices – as the surge in resource investment last decade boosts supply.
Technological innovation and automation.
For bonds, the best predictor of future medium-term returns is current bond yields. If a 5-year bond is held for five years its initial yield will be its return. We use 5-year bond yields.
The second column shows each asset’s current income yield, the third shows their 5-10 year growth potential, and the final column their total return potential.
We assume inflation averages around or just below central bank targets.
For Australia we have adopted a relatively conservative growth assumption reflecting constrained commodity prices and slower productivity growth.
We allow for forward points in the return projections for global assets based around current market pricing – which adds 0.6% to the return from world equities.
Combining the returns indicates the implied return for a diversified growth mix of assets has fallen to 6.2% pa.
Key observations
Several things are worth noting from these projections.
The medium-term return potential using this approach has continued to fall due largely to the rally in most assets which has pushed investment yields lower.
Government bonds offer low returns due to ultra-low yields.
Unlisted commercial property and infrastructure continue to come out relatively well, reflecting their higher yields.
Australian shares stack up well on the basis of yield, but it’s still hard to beat Asian/emerging shares for growth potential.
The downside risks to our medium-term return projections are that: the world is plunged into another recession driving another major bear market in shares or that investment yields are pushed up to more normal levels as inflation rebounds causing large capital losses. Just allow that drawdowns in returns tend to be infrequent but concentrated and it’s been a while since the last big one – see next chart.
The upside risks are (always) less obvious but could occur if we see improving global growth but inflation remaining low.
First, have reasonable return expectations. Low yields & constrained GDP growth indicate it’s not reasonable to expect sustained double-digit returns.
Second, much of this reflects very low inflation - real returns haven’t fallen as much.
Finally, focus on assets with decent sustainable income flow as they provide confidence regarding future returns.